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Cheers for 401(k) Tiers

Aligning different segments of investments with individual levels of risk appetite and inclination puts more control in the hands of plan participants.

Everything seemed to be going well for future retirees a few years back. The economy was stable, the stock market was riding high and assets in 401(k) defined-contribution plans were galloping in value. Participants boasted about being able to retire at age 60, an almost quaint recollection now, since they’re still at their desks, wondering what went wrong. Employers that sponsor these plans are wondering the same thing. Workers who can’t retire for financial reasons and hang on to their jobs for longer than their employers would like aren’t easy to shed.

This can create productivity problems, since the employees aren’t exactly happy about the situation, either. And if workers blame plan sponsors for the paltry value of their retirement investments, it heightens corporate fiduciary risk. Under ERISA, fiduciaries can be held personally liable for losses to a benefit plan incurred as a result of alleged errors, omissions or breach of their fiduciary duties.

Now there is a relatively new way of helping employees invest in their retirements. Called tiered investment strategies, the approach aligns particular types of investments with the investing appetite and inclinations of plan participants. If you’re someone who likes to call the shots on your investments, there is a tier for that. If you’re at the other end of the spectrum and want nothing to do with how your money is invested, there’s a tier for that, too.

Depending on the plan sponsor and provider, there are typically three or four tiers to choose from. Proponents say the tiers help employees design an optimal investment plan based on their age, income and other investments, risk appetite and target date for retirement. The approach counters the “paralysis by analysis” that plan participants grappled with in the past—all those confounding investment choices that made the selection process a game of wishful dart tossing.

Tiers are also touted for their value to employers, which isn’t primarily lower costs. Rather, giving participants a framework to organize their thinking around investing should reduce investor risk, result in a happier, more productive workforce, guide retirement at a proper date and even lower the risk of fiduciary liability. While no one is arguing that tiers are today’s equivalent of yesterday’s defined-benefit pensions, many say they are at least a step in the right direction.

Among the companies that have introduced the tiered investment concept is Paychex, which sees significant benefits from a fiduciary standpoint. The Rochester, N.Y.-based provider of payroll and HR services, with $2 billion in 2010 revenue, offers its 401(k) participants four tiers to choose from and built its investment policy statement around that approach.

“The tiers help provide a road map for our investment decisions in the plan, serving as a crucial guide for making investment decisions and carrying out due diligence processes,” says CFO John Morphy.

So what are the respective tiers? Well, they differ depending on the plan provider and sponsor but tend to fall into similar buckets. A typical Tier One comprises what providers call a “set it and forget it” group of investments, such as target-date funds, also known as lifecycle or age-based funds. These are usually mutual funds that invest in both stocks and bonds, with the asset mix becoming more conservative as the target date (retirement) approaches.

Tier One is designed to appeal to someone without the expertise to create an investment portfolio. “They’re for individuals wanting a simple investment solution,” says Rick Amering, manager of compensation and benefits services at Paychex. Approximately 88% of the assets in the Paychex plan are in Tier One class investments.

“They’re for those who lack the time and interest to plan their retirements,” agrees Gerry Mullane, principal and director of institutional sales at provider Vanguard. “There’s sufficient choice without overloading them with too much choice.”

A typical Tier Two might include a range of low-cost index funds (usually a mutual fund or exchange-traded fund) that track such market segments as U.S. stocks, international stocks, the S&P 500, bonds and even a bit of cash. The investment choices are limited yet flexible, and are broadly diversified and relatively predictable, moving in line with the market sector or benchmark they’re designed to mimic.

“This is really simple stuff where the finance manager and HR manager sit down with the provider and pick funds that are low-cost and offer few if any surprises,” says Pamela Hess, director of retirement research at Aon Hewitt. “They’re for employees who want to be more involved than those selecting the first tier but not as engaged as those selecting the other tiers.”

The low cost has to do with the lack of active management. Tier Three usually is where active management kicks in, with funds run by portfolio managers who try to outperform the market. “This tier is where you see broader and more specialized choices, which are designed for experienced, knowledgeable and confident investors,” says Chuck Black, senior vice president of personal and workplace investing at plan provider Fidelity.

You also see higher cost. The average ongoing management expense of an actively managed fund is about one percentage point more than those for passively managed funds like the index funds in Tier Two.

The third tier offers a larger choice of investments, including Treasury Inflation-Protected Securities (TIPS), real estate investment trusts (REITs) and small cap funds. Tier Four, as you would imagine, is aimed at more sophisticated investors and includes a brokerage account that allows participants to choose specific stocks and bonds, in addition to the usual mix of funds, in designing their portfolios. At Paychex, the fourth tier also includes the option to convert investments at some juncture into an annuity providing a guaranteed retirement income. “This makes it more like a defined-benefit plan,” says Ron Shaw, the company’s 401(k) and deferred compensation analyst.

Is there value in cleaving investments into different tiers? Apparently so. For one thing, it’s a lot less confusing for participants. Hess points out that in the good old early days of 401(k) plans, there were few choices for participants to make. “They looked like defined-benefit plans—they were low cost, with a narrow number of funds,” she says. “And then the mutual fund industry got into the game in the 1990s, and the market shifted. At the same time, participants wanted more choices, given the rise in certain sectors like technology, which was skyrocketing. They wanted a piece of the action, and it was hard for the plan sponsors to fight it.”

As time progressed, the list of choices grew and grew and became increasingly numbing from a decision standpoint. Then the financial crisis hit and, well, you know the rest. “The sponsors are trying to adopt the practices now that were so successful with the defined-benefit plans, such as keeping costs in check, educating participants about risk-taking and providing one-stop solutions,” Hess adds. “We’re encouraging our clients to go the tiered route. It’s gone from being a leading industry practice to being a best practice.”

Paychex CFO Morphy agrees. “By segmenting the investment choices in a logical manner by tier, we’re able to provide more focused education about each tier that’s easier for employees to understand and digest,” he says. “This way they can make more informed decisions.”

And companies see real value in having better informed plan participants. “Sponsors have a fiduciary role in ensuring that their employees are able to achieve a secure retirement,” says Kristi Mitchem, global head of defined contribution at plan provider State Street Global Advisors, which offers a tiered menu to its employees. “The value in this from a financial standpoint is that if employees better understand the benefit structure, they’re likely to have higher levels of engagement, be more productive and retire when they’re supposed to.”

Tiers also may make employees less intimidated about investing, given the objective of aligning specific types of investments with individual investor appetite and tolerance, says Nicole Boyson, assistant professor of finance at Northeastern University in Boston. “It’s a step forward in that they’re designed to help people organize the way they think about investments,” Boyson explains. “If you consider yourself a sophisticated investor—someone like a CFO, for instance—the fourth tier is a solid option because of the brokerage element. If you don’t have a degree in finance, there are other choices more suited to your expertise.”

The previous method of assembling investments into a 401(k) portfolio “created anxiety,” she adds. “You’d be given this huge list and told, ‘Here is a money market fund and it is super safe, and here is some other stuff that is less safe.’ You’d then opt for the low-risk bond fund and lose money, while the riskier investments that others had selected grew in value. People felt lost in the dark.”

To illuminate these choices, some plan sponsors like SunTrust Bank sum up the purpose of each tier in a few words. “We have three tiers aimed at three different types of investors—the ‘Do It for Me,’ the ‘Help Me Do It,’ and the ‘Do It Myself’ investor,” says Larry Elliott, group vice president and education team manager at the Atlanta-based financial services company, with $173 billion in total assets. “Most participants automatically know which one they’re right for, helping them to identify the resources they need to make well-informed decisions.”

From a fiduciary risk standpoint, tiers may lower plan sponsor liability and even costs. “There has been a lot of legal and regulatory scrutiny of late of 401(k) plan fees and investment lineups,” says Vanguard’s Mullane. “The majority of costs associated with the plans come from the investment management fees. One way to lower plan fees is to put in indexed funds, which are lower cost than actively managed funds. If more of the participants’ money moves in that direction, it’ll bring down plan costs. And since investments like indexed funds that are more quantitative in nature are easier to select and monitor for company investment committees, it should theoretically lower fiduciary risk.”

Black from Fidelity concurs. “Previously, there were so many options for participants to choose from that employers felt exposed from a fiduciary liability standpoint,” he says. “It’s the sponsor’s job to track all these funds—hence the desire among fiduciaries to have fewer options to cover. Tiers have provided a methodology to do this.”

Others are less sure the tiers have value from a fiduciary liability standpoint. “Tiers may lower or increase fiduciary risk,” says Thomas White, a partner and an employee benefits lawyer at Chicago-based law firm Arnstein & Lehr. “Is the fourth tier with a brokerage account the least risky alternative? Maybe yes and maybe no. I like tiers, but nothing is guaranteed when it comes to investing.”

Boyson shares this doubt. “An indexed fund could be riskier than an actively managed fund, even though they tend to outperform target-date funds over time,” she says. “I agree that they’re cheap and are a way to save money, but in terms of lowering fiduciary liability, I don’t see the connection.”

Amering from Paychex does, however. “By slicing and dicing investments into different tiers, it becomes more evident where we need to make changes,” he says. “From a benchmarking standpoint, it’s much more helpful to the investment committee. I would agree that the tiered approach lowers fiduciary risk.”

Aon Hewitt’s Hess has a slightly different take. “If the participant has more confidence, the fiduciary has more confidence that they’re doing everything right,” she says. SunTrust’s Elliott shares her view. “If you’re giving employees tools and resources to take a complicated subject and understand it in a more organized way, you’re doing the best you can do,” he says.

And maybe that’s the point to tiers, after all. They show that employers have taken to heart the pain the financial crisis caused for their workers. Even though tiers aren’t grandpa’s pension, they offer a methodical way for employees to create lower-cost and higher-value 401(k) portfolios. At least, that’s the hope.

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